Compounding, or rather compound interest, is a passive form of wealth creation. Contrary to popular opinion, investors tend to associate the phenomenon only with fixed deposits. However, mutual funds can also utilize the power of compounding to accelerate the wealth creation process. In this article, we’re going to take a look at how compounding works in mutual funds. But before we get there, let’s quickly go through the concept of compounding in general.

What is Compounding?

Compounding is the process where an asset’s returns are reinvested in a bid to earn higher returns. Here’s an example to help you understand how it works.

Assume that you open a cumulative fixed deposit by investing Rs. 1 lakh. The tenure of the deposit is 5 years, and the interest rate is 10%. A RD calculator is an online tool that you can use to plan your RD investments. In a recurring deposit, you invest a fixed sum each month, for a specified investment tenure. The frequency of compounding is annual, which means that at the end of every year, the interest that accrued on the principal amount of that year is reinvested. The reinvestment of interest continues till the deposit matures.

At the end of the 5-year tenure, your principal investment of Rs. 1 lakh would have increased to about Rs. 1,61,051, which includes the interest of about Rs. 61,051.

If your fixed deposit didn’t use compounding, you would have only been able to generate interest of about Rs. 50,000. However, thanks to compound interest, you were able to generate additional interest of about Rs. 11,051 (Rs. 61,051 - Rs. 50,000). Explore the Compound interest Calculator and get deeper insights.

This is how the concept of compounding can help you accelerate the wealth creation process.

How Compounding Works In Mutual Funds?

Now that you’re aware of how compound interest works, let’s take a quick look at how it works in the context of mutual funds.

As you might already be aware, mutual funds invest your money in a basket of different stocks. These stocks occasionally declare dividends, which are received by the fund house managing the mutual fund. The fund house then distributes the dividend to you in cash on a pro-rata basis, based on the number of units that you hold.

As an investor, if you wish to make use of compounding, you can choose to opt for a dividend reinvestment plan. When you opt for such a plan, the dividends that you earn are automatically reinvested into the same mutual fund, much like a cumulative fixed deposit. As a result of this reinvestment of dividends, you end up with more units from the fund.

When this dividend reinvestment is carried out over a long period, say for about 10 years, the number of units that you end up with will be significantly higher than what you would have had if you hadn’t opted for the reinvestment option.

Here’s an example to help you understand how compounding works in mutual funds. Assume that you purchase 1,000 units of a mutual fund at a NAV of Rs. 25 per unit. You intend to hold this investment for the next 10 years. Every year, you get a dividend of roughly Rs. 100, which you promptly reinvest into the same fund. This dividend reinvestment activity gives you about 4 additional units each year. Assuming that you continue reinvesting the dividends throughout the 10-year tenure, you would ultimately end up with 1,040 units instead of 1,000 units.

Conclusion

As you can see, by simply opting for the dividend reinvestment plan, you can effectively leverage the compounding effect and increase returns significantly. And the best part of it is that all of this happens passively without any active involvement on your part.

Now, if you’re planning on investing in mutual funds, ensure that you have a trading and demat account in your name. If you would like to open a Demat accountand a trading account, all that you need to do is visit the website of Motilal Oswal. The entire application process is digital and takes only a few minutes to complete. Once you have your trading and demat account up and running, you can then proceed to invest in stocks, mutual funds, upcoming IPOs, and a whole lot of other securities.